Why Return on Assets (ROA) is a critical and preferred metric for evaluating banks, investment banks, and financial companies (as opposed to Return on Total Capital, or ROTC).

ROA of Banks, Investment Banks and Financial Companies

https://myinvestingnotes.blogspot.com/2009/06/rotc-of-banks-investment-banks-and.html

Banks, investment banks and financial companies rely on borrowing large amounts of money that they hope to loan out at higher interest rates to businesses and consumers.

A company like Freddie Mac, which deals in residential mortgages, carries $175 billion in short-term debt and $185 billion in long-term debt. If your business is borrowing money at 6% and loaning it out at 7%, there is no way your return on total capital ROTC is going to even approach 12%.

In these instances, Warren Buffett likes to look at what the bank or finance company earned in relation to the total assets under its control. The rule here is, the higher the better. Anything over 1% is good and anything over 1.5% is fantastic.


Learning Point

With banks, investment banks, and financial companies, look for a consistent return on assets ROA in excess of 1% and a consistent return on shareholders' equity ROE in excess of 12%.

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Why Return on Assets (ROA) is a critical and preferred metric for evaluating banks, investment banks, and financial companies (as opposed to Return on Total Capital, or ROTC). Here is a discussion and summary of the key points:

Core Discussion Points:

1. Unique Business Model: These institutions are fundamentally in the "business of money." Their core activity is financial intermediation: borrowing at lower rates (e.g., from deposits or debt markets) and lending/investing at higher rates. This makes them highly leveraged (carry massive debt) by design.

2. Why ROA (not ROTC) is Key:

   • Their balance sheets are dominated by interest-bearing liabilities (debt). Using Return on Total Capital (ROTC), which includes this debt, would be misleading.

   • As the Freddie Mac example illustrates: borrowing at 6% and lending at 7% yields a slim net interest margin. When this slim profit is measured against the enormous total capital (equity + massive debt), the ROTC will always appear very low—even if the bank is run efficiently.

   • ROA cuts through this. By measuring Net Income / Total Assets, it assesses how effectively management is using the assets it controls (primarily loans and investments) to generate profits, regardless of how those assets were financed (with debt or equity).

3. Buffett's Benchmark Rules of Thumb:

   • ROA > 1% = Good. Indicates solid asset utilization and prudent risk management.

   • ROA > 1.5% = Fantastic. Suggests exceptional operational efficiency and/or a valuable, low-cost funding base (like a strong deposit franchise).

4. The Dual Mandate (ROA & ROE): The final learning point introduces the complete picture for evaluating these firms:

   • ROA (>1%): Measures operational efficiency and asset quality. A consistent ROA shows the core lending/investing business is sound.

   • ROE (>12%): Measures returns to shareholders. Because these firms use high leverage (debt), a solid ROA can be magnified into a high ROE. A consistent ROE above 12% indicates the firm is not only efficient but also generating attractive returns on its equity capital.

Summary:

For banks and financial companies, the standard return metrics used for industrial firms are distorted by their inherent, massive leverage. Therefore:

• Focus on Return on Assets (ROA) to judge the efficiency and profitability of their core lending/investment operations. Warren Buffett considers a consistent ROA above 1% good and above 1.5% excellent.

• Also consider Return on Equity (ROE) in conjunction with ROA. A strong, consistent ROE (exceeding 12%) indicates that the firm's operational efficiency (high ROA) is successfully being translated into strong returns for shareholders through prudent use of leverage.

In essence: For financial institutions, ROA tells you if they are good bankers, while ROE tells you if they are good investments for shareholders. A well-run bank should excel at both.

Buffett (1980): The true value is determined by the intrinsic value of the company and not the dividends.

Wednesday, 31 March 2010

Buffett (1980): The true value is determined by the intrinsic value of the company and not the dividends.

https://myinvestingnotes.blogspot.com/2010/03/buffett-true-value-is-determined-by.html

Warren Buffett in his 1980 letter to the shareholders of Berks

hire Hathaway:

"The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage."

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Buffett’s thinking from that 1980 letter.

Let’s break down and expand upon the key ideas you’ve highlighted:

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1. Intrinsic Value vs. Dividends in Accounting

Buffett was criticizing the accounting convention that focused on dividends received from partially owned companies as the measure of value for the owning company.
He argued that the real worth to Berkshire wasn’t the dividend payout, but the proportionate share of the underlying business’s intrinsic value — regardless of whether those earnings were paid out or retained.

Your Indian example — valuing M&M based only on dividends from Tech Mahindra, rather than 20% of Tech Mahindra’s intrinsic value — perfectly illustrates the flawed accounting viewpoint.
If Tech Mahindra reinvests its earnings profitably, the retained earnings compound and increase the intrinsic value of M&M’s stake far beyond the dividends received.
Accounting rules at the time (and to a large extent still today) fail to capture this unless ownership exceeds a certain threshold (e.g., consolidation or equity method with impairment tests, but still not intrinsic-value based).

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2. Retained Earnings: Value Depends on Use

Buffett’s core point:

“The value of retained earnings is determined by the use to which they are put and the subsequent level of earnings produced.”

This means it’s not retention itself that creates value, but the return on reinvested capital. If a business can reinvest earnings at high rates of return, retaining earnings adds more value than paying dividends.
If it can’t find good reinvestment opportunities, returning capital to shareholders (via dividends or buybacks) is better.

For partial ownership, even if you don’t control the capital allocation decisions, if the investee company reinvests earnings well, your share of its value grows without you receiving cash dividends.
That’s why Berkshire’s holdings in companies like Coca-Cola or See’s Candies were worth far more than the dividends indicated — because retained earnings were deployed into high-return operations.

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3. Buybacks at a Discount to Intrinsic Value

The second quote contrasts corporate acquisitions (often full-price or overpay in competitive bidding) with stock buybacks in the open market (where shares can sometimes be bought far below intrinsic value).

Key takeaways:

• Acquisition market = auction between corporations → often pays premium to intrinsic value.

• Stock market = sometimes an auction where sellers panic → can buy parts of a business at a discount.

Buffett loves buybacks when:

1. The stock trades below intrinsic value.

2. The company has excess cash and no better investment opportunities.

Buybacks increase per-share intrinsic value by reducing shares outstanding, effectively giving remaining shareholders a larger claim on future earnings at a bargain price.

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4. Relevance Today

These principles remain central to value investing:

• Look-through earnings: When evaluating holdings, include your share of undistributed earnings of subsidiaries/associates if they are reinvested well.

• Capital allocation priority:

  1. Reinvest in high-return projects.

  2. Acquire other businesses at fair prices.

  3. Buy back stock when cheap.

  4. Pay dividends if no better use.

The accounting standards (e.g., IFRS 9, ASC 323) still don’t fully reflect “look-through” intrinsic value for minority holdings — they focus on dividends, fair value changes, or equity-accounted earnings, but not necessarily the full economic value of retained earnings compounding inside the investee.

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5. Buffett’s Broader Philosophy

The 1980 letter segment you’re discussing fits into Buffett’s larger framework:

• Own businesses, not stocks → value comes from underlying business performance.

• Mr. Market offers opportunities to buy/sell pieces of businesses at irrational prices.

• Management’s job is to increase per-share intrinsic value over time, not to cater to short-term stock prices.

By ignoring dividends as the sole measure of value from investments and focusing on the growth in intrinsic value, Buffett built Berkshire’s worth far beyond what dividend-based accounting would suggest.

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SUMMARY

Here is a summary of the article's key points:

Core Argument

Warren Buffett, in his 1980 letter, argues that the true economic value of a company's stake in another business is not determined by the dividends it receives, but by its share of the intrinsic value of the underlying business. Accounting standards that focus on dividend income are misleading.

Main Points

1. Intrinsic Value Over Dividends:

   • If Company A owns 20% of Company B, the stake should be valued as 20% of Company B's intrinsic value, not just 20% of the dividends paid out. This is because retained earnings reinvested into the business can create far more long-term value.

   • Example: Valuing M&M based only on the dividends from its stake in Tech Mahindra would be incorrect; one must value its 20% ownership of Tech Mahindra itself.

2. Value of Retained Earnings:

   • The worth of retained earnings depends entirely on how effectively they are reinvested. If a business can reinvest earnings at a high rate of return, retaining them creates more value than paying them out as dividends.

3. Buybacks vs. Acquisitions:

   • Acquisitions often occur in a competitive auction, forcing acquirers to pay a "full" or inflated price.

   • Stock Buybacks, however, allow a company to buy parts of its own business in the open market, often at a significant discount to intrinsic value, especially during market panics.

   • Buffett strongly advocates for buybacks when a company's stock is trading below its intrinsic value, as it is the most efficient use of capital to increase per-share value for remaining shareholders.

Conclusion

Buffett’s philosophy centers on economic reality over accounting convention. A value investor should focus on the growth of intrinsic value from reinvested earnings and take advantage of market irrationality to buy ownership stakes at a discount.

ROA of Banks, Investment Banks and Financial Companies

ROA of Banks, Investment Banks and Financial Companies

https://myinvestingnotes.blogspot.com/2009/06/rotc-of-banks-investment-banks-and.html

Banks, investment banks and financial companies rely on borrowing large amounts of money that they hope to loan out at higher interest rates to businesses and consumers.

A company like Freddie Mac, which deals in residential mortgages, carries $175 billion in short-term debt and $185 billion in long-term debt. If your business is borrowing money at 6% and loaning it out at 7%, there is no way your return on total capital ROTC is going to even approach 12%.

In these instances, Warren Buffett likes to look at what the bank or finance company earned in relation to the total assets under its control. The rule here is, the higher the better. Anything over 1% is good and anything over 1.5% is fantastic.



Learning Point

With banks, investment banks, and financial companies, look for a consistent return on assets ROA in excess of 1% and a consistent return on shareholders' equity ROE in excess of 12%.

 

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Also read:

https://myinvestingnotes.blogspot.com/2025/12/why-return-on-assets-roa-is-critical.html

Why Return on Assets (ROA) is a critical and preferred metric for evaluating banks, investment banks, and financial companies (as opposed to Return on Total Capital, or ROTC).

ROTC, ROA, ROE and Buffett's Durable Competitive Advantage

ROTC, ROA, ROE and Buffett's Durable Competitive Advantage

https://myinvestingnotes.blogspot.com/2009/06/relating-rotc-and-roa-to-durable.html

1. Warren Buffett has learned that a consistently high return on total capital is indicative of a durable competitive advantage. He is looking for a consistent ROTC of 12% or better.

2. With banks and finance companies he looks at the return of total assets ROA to determine if the company is benefitting from some kind of durable competitive advantage. Warren Buffett looks for a consistent return on assets ROA in excess of 1% (anything over 1% is good, anything over 1.5% is fantastic) and a consistent ROE in excess of 12%.

3. In situations where the entire net worth of the company is paid out, creating a negative net worth, Warren Buffett has only made investments in those companies that show a consistent ROTC of 20% or more. The high ROTC is indicative of a durable competitive advantage.

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Here is a detailed elaboration, discussion, and summary of Warren Buffett's use of ROA, ROE, and ROTC as indicators of a durable competitive advantage (often called an "economic moat").

Elaboration: The Three Metrics and Their Buffett Context

1. ROTC (Return on Total Capital)

• What it is: Measures how efficiently a company uses all its permanent capital (both equity and long-term debt) to generate profits. Formula: Earnings Before Interest & Taxes (EBIT) / (Shareholders' Equity + Long-Term Debt).

• Buffett's Threshold: A consistent 12% or better. He looks for consistency over time, not just a single high year. This indicates the company can deploy large amounts of capital at high rates of return—a key sign of a moat.

• Key Insight: Because it uses pre-interest earnings (EBIT) and includes debt, ROTC neutralizes the effects of different capital structures (how much debt vs. equity a company uses). It focuses purely on the operating efficiency of the core business.

2. ROA (Return on Assets) & ROE (Return on Equity) for Financials

• Why separate for banks/financials? For these companies, debt is the raw material of the business (e.g., deposits for banks, premiums for insurers). Their assets are predominantly financial (loans, securities). Therefore, standard ROTC is less meaningful.

• ROA (Return on Assets): Net Income / Total Assets. Buffett looks for consistently over 1% (excellent if over 1.5%). A consistently high ROA for a bank indicates it is skilled at underwriting (lending) and investing without taking excessive risk. It suggests pricing power, operational efficiency, and a valuable, low-cost deposit base—all forms of a competitive advantage.

• ROE (Return on Equity): Net Income / Shareholders' Equity. Even for financials, Buffett seeks consistently over 12%. This ensures the company is not just efficient with assets but also generates a superb return for its owners.

3. The "Negative Equity" Exception & High ROTC Bar

• The Scenario: Some exceptional companies generate so much cash that they can pay out all their cumulative earnings as dividends or share buybacks, effectively reducing their retained earnings (and thus shareholder equity) to zero or negative. Think of powerful brands like Moody's or See's Candies.

• Buffett's Adjusted Metric: In these cases, ROE becomes distorted or infinite. Therefore, he reverts to ROTC, but raises the bar significantly to 20% or more. This extreme profitability with minimal capital reinvestment is the ultimate sign of a durable competitive advantage—a "toll-bridge" or "franchise" business that prints money.

Discussion: The Underlying Philosophy and Connections

1. Consistency is the True Signal: Buffett is not looking for a single year's spike. He looks for a decade or more of consistently high metrics. This consistency proves the advantage is durable and can withstand economic cycles, competition, and management changes. Volatility in these returns suggests a cyclical commodity business, not a moat.

2. The Hierarchy of Metrics Reflects Business Model:

• For most businesses (Coca-Cola, Apple): ROTC is the primary gauge because it isolates business quality from financing decisions.

• For financial businesses (Bank of America, American Express): ROA is the key operational metric, supplemented by ROE.

• For capital-light franchise businesses: An extremely high ROTC (20%+) is the tell-tale sign, even trumping ROE.

3. The "Why" Behind the Numbers: These metrics are the output, not the cause. A high and consistent ROTC/ROA/ROE is the result of the durable competitive advantage, which can stem from:

• Brand Power (Coca-Cola): Allows pricing power.

• Cost Advantages (GEICO): Creates a low-cost structure.

• Network Effects (American Express): Makes the service more valuable as more use it.

• High Switching Costs (See's Candies, Moody's): Locks in customers.

4. The Avoidance of "Look-Through" Debt: By focusing on ROTC (using EBIT) for industrials, Buffett avoids being fooled by a high ROE achieved through excessive leverage (debt). A highly leveraged company can have a high ROE but be very risky. Buffett prefers profits from business strength, not financial engineering.

Summary: The Buffett Framework for Identifying a Moat

In essence, Warren Buffett uses these profitability ratios as a forensic tool to identify a business's underlying economic reality. He seeks consistent excellence in these metrics as evidence that a company possesses a durable competitive advantage (moat). The specific metric he emphasizes depends on the business model, but the ultimate goal is the same: to find a business so fundamentally strong that it can generate high returns on capital for many years into the future, with minimal need for additional investment. This is the engine behind Berkshire Hathaway's compounding value.

Warren Buffett's strategy, uses the combination of ROE and ROTC as a powerful filter to identify exceptional businesses.

The Right Rate of Return on Total Capital (ROTC)

https://myinvestingnotes.blogspot.com/2009/06/right-rate-of-return-on-total-capital.html

Warren Buffett looks for a consistent ROTC of 12% or better.

Problem with ROE

The problem with looking at high rates of return on shareholders' equity is that some businesses have purposely shrunk their equity base with large dividend payments or share repurchase programs. They do this because increasing the return on shareholders' equity makes the company's stock more enticing to investors. Thus, you will find companies in a price-competitive business, like General Motors, reporting high rates of return on shareholders' equity. To solve this problem, Warren Buffett looks at the return on total capital (ROTC) to help him screen out these types of companies.


ROTC

ROTC is defined as the net earnings of the business divided by the total capital in the business. (Total capital = Equity + Long-Term Debts + Short-Term Debts).

Warren Buffett is looking for a consistently high rate of ROTC, AND, a consistently high rate of ROE.

General Motors' return on equity for the 10-year period (1992 to 2001) was an average annual rate of 27.2%, which is very respectable but suspect because of the 0% return in 1992. Its total return on capital (ROTC) for the 10-year period shows a different story. Its 9.5% average is not enticing. Compare this to H&R Block, which logged in an average annual rate of ROE of 21.5% and an average annual total return on capital (ROTC) of 20.7%.

Take Home Message

• Companies with a durable competitive advantage will consistently earn both a high rate of ROE and a high rate of return on total capital (ROTC). Again, the key word is CONSISTENT.
• Companies in a price-competitive business, will typically earn a low rate of ROTC.
• Warren Buffett looks for a consistent ROTC of 12% or better.

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Here is a detailed expansion and discussion of the provided text, followed by a concise summary.

Expansion and Discussion

The core message is that while Return on Equity (ROE) is a popular metric for judging a company's profitability, it can be manipulated and is often insufficient on its own. The solution is to use it in conjunction with Return on Total Capital (ROTC), which provides a more holistic view of a company's true operational efficiency.

1. The Problem with ROE: A Flawed King

Return on Equity (ROE) measures how effectively a company generates profits from every unit of shareholders' equity. It's calculated as:

ROE = Net Income / Shareholders' Equity

The Problem: A high ROE can be a mirage. Companies can artificially inflate their ROE not by increasing earnings, but by reducing the denominator—Shareholders' Equity. This is done through two primary methods:

• Large Dividend Payments: This directly transfers equity from the company to shareholders.

• Share Buybacks: When a company repurchases its own shares, the money used is deducted from shareholders' equity, shrinking the equity base.

Why do they do this? A higher ROE makes the company appear more efficient and profitable to investors who rely on this single metric, potentially driving up the stock price. The example of General Motors is perfect. As a capital-intensive, price-competitive business in the auto industry, its underlying profits are not exceptionally high. By shrinking its equity base, it could report a seemingly "very respectable" average ROE of 27.2% over a decade, masking its true competitive weakness.

2. The Solution: ROTC - The True Measure of Efficiency

Return on Total Capital (ROTC) broadens the perspective by considering all the permanent capital used to run the business, not just equity. It is calculated as:

ROTC = Net Earnings / Total Capital
Where Total Capital = Shareholders' Equity + Long-Term Debt + Short-Term Debt

ROTC answers the question: "Regardless of how this business is financed (with equity or debt), how good is it at generating returns on the entire pool of capital employed?"

This metric is much harder to manipulate with financial engineering. A company cannot easily hide its need for debt and equity to fund its operations. When we apply ROTC to General Motors, the story changes dramatically. Its impressive 27.2% ROE collapses into a mediocre 9.5% ROTC. This reveals that GM is not a particularly efficient generator of profits relative to the massive amount of capital (factories, equipment, inventory) it requires to operate.

In contrast, H&R Block shows consistency. Its ROE (21.5%) and ROTC (20.7%) are both high and very close to each other. This indicates that the company is genuinely profitable from its operations and is not relying on debt or equity shrinkage to appear successful. This is a classic sign of a company with a durable competitive advantage (in H&R Block's case, a strong brand and a recurring, essential service).

3. The Take-Home Message: The Buffett Filter

Warren Buffett's strategy, as described, uses the combination of ROE and ROTC as a powerful filter to identify exceptional businesses.

• The Durable Competitive Advantage: Companies with a wide "economic moat" (a strong brand, pricing power, proprietary technology) can consistently earn high returns on both equity and total capital. They don't need to compete solely on price, which erodes margins. Their high ROTC proves their operational excellence, and their high ROE confirms that this excellence translates into strong returns for shareholders. Consistency is key—it shows the advantage is structural, not a one-time event.

• The Price-Competitive Business: Companies in industries like automotive, airlines, or commodity manufacturing typically earn a low ROTC. They are forced to compete on price, and the immense capital required for their operations (factories, fleets of planes) generates relatively low returns. Their profits are cyclical and thin.

• The Benchmark: Buffett looks for a consistent ROTC of 12% or better. This hurdle rate signifies a business that generates more than enough profit to cover its cost of capital and create genuine value for its owners over the long term.

Summary

In essence, the passage warns against relying solely on Return on Equity (ROE), as it can be artificially inflated by share buybacks or dividends, making a company look more efficient than it is. The solution is to also analyze Return on Total Capital (ROTC), which measures profitability against all capital invested (equity + debt), providing a clearer picture of true operational efficiency.

Key Conclusions:

1. A high ROE can be deceptive. Always check if it's driven by a shrinking equity base rather than growing earnings.

2. ROTC is the reality check. A genuinely great business will show both a high ROE and a high ROTC.

3. Consistency is the hallmark of quality. Companies with a durable competitive advantage, like H&R Block in the example, will post consistently high numbers for both metrics.

4. Use them together. By demanding both a consistently high ROE and a consistently high ROTC (Buffett's benchmark is 12%+), an investor can screen out financially engineered mirages and identify truly exceptional, profit-generating machines.